Current Liabilities and Current Assets are a major component of the Statement of Financial Position that is prepared by every company annually at the end of the year.
The SOFP represents the financial position of a company at the year-end and constitutes of balances of capital and all types of assets and liabilities owned by the company.
What are Current Liabilities?
Liabilities are obligations of a company to repay the other entities it has obtained credit from. The current liabilities are obligations that must be settled within a period of 12 months. In other words, current liabilities are short-term liabilities.
Examples of current liabilities include payment to suppliers who’ve sold you goods at credit, interest accrued that must be settled annually through installments, rent payable to your landlord, and more.
What are Current Assets?
Assets, in general, are resources of a company from which cash or benefits are expected in the future. The current assets are those assets that are expected to generate cash flow within a period of 12 months.
Examples of current assets include your accounts receivable (customers who owe you money for buying good from you on credit), prepaid rent to your landlord, prepaid interest, cash, closing inventory that you expect to sell within the next accounting period, and more.
What Happens When Current Liabilities Exceeds current Assets?
First, let’s take a look at what working on capital is. It is a financial metric to measure the operational liquidity of a company and can be positive, zero, or negative. Working capital is one of the significant ways of analyzing the current assets and current liabilities of a company.
It is computed by deducting the current liabilities from current assets. Negative working capital means the current assets are lesser than the current liabilities. Hence, a negative working capital implies that the company is unable to finance its short term needs through operational cash flow.
But wait, let’s not jump to conclusions! If the working capital is negative for a short time, it may mean that the company had a large outlay of cash resulting in a small balance of current assets or a large acquisition of credit resulting in a massive balance of current liabilities.
Both situations may occur when the company purchases raw materials for urgent bulk order by cash or credit, respectively.
However, if the working capital persists to stay negative for an extended period of time, it indicates that the company is facing a liquidity crisis and has been financing its operational needs by borrowing, or issuing shares to get funds, or other unhealthy means.
Effect on Financial Analysis:
When current liabilities exceed current assets, it also impacts the financial analysis of a company poorly.
When current ratio and quick ratio drops below 1, it indicates that the company is facing liquidity problems and is short of cash for financing its day-to-day activities.
This is a major turn off for potential investors who heavily rely on financial analysis reports before investing in a company.